When it comes to measuring business performance how do you define success? A decade or more ago popular opinion would base business success on revenue growth and increased profitability. But what about now? Some of the biggest names in business (Uber, Tesla, Shopify, etc) have yet to achieve profitability! As business models and investor interests evolve so must our performance dashboards. Although some entrepreneurs may see a diversion from profitability as a refreshing excuse to disregard traditional and tedious accounting indicators altogether, the evolved models actually command more dependence on tracking key performance indicators to survive.
It's important to understand which financial metrics are most applicable to your business' model structure and your overall goals. Recently I shared my recommended dashboard metrics for Service Businesses but these may not necessarily apply if your business is a different model. There is, however, one metric that all scaling businesses should know intimately: Lifetime Value of a Customer - ("LTV").
I often hear business leaders using top line metrics like 'sales' or 'revenues' when emphasizing the relative importance of a customer relationship, but LTV represents a more appropriate valuation method. If you compare the LTV of different customers you will get a better sense of their relative value to your business. And when viewed in aggregate you can best understand the net financial gain you should expect on average from adding new customers. It is only then that you are in a good position to set an appropriate sales and marketing budget for growing your business in a fiscally responsible way. (= Success!)
LTV tells you how much incremental margin you should be able to add to your business over the lifetime of servicing the customer. This metric factors in your selling price and the number of purchases a customer will make over the life of your relationship but also factors in the variable costs you incur as a result of the sale. To calculate LTV you also need to understand your customer retention. How long do customers continue to purchase from you? (One time, or again and again over many years?)
Once you know your LTV you can then set an appropriate target spend for acquiring new customers ("CAC").
How do you calculate LTV and CAC?
LTV: Take your Average Revenue per Account (ARPA) multiplied by your Gross Margin % (GM%), multiplied by the life time span of customer (LT).
CAC: Sum your total Sales and Marketing spend and divide it by the number of New Customers you gained during the same period.
Divide your LTV/CAC to see how your business is performing. If you are looking to scale your business you should aim for an LTV to CAC ratio to be at least 3:1.
Need help? Your internal accounting team should be able to calculate this for your business, but if not you can reach me at firstname.lastname@example.org